The causes and consequences of rising inequality have stirred a lively debate on appropriate policy responses. This column reviews how governments have successfully used fiscal policy to address distributive concerns. It also examines the policy alternatives that countries can pursue in order to reduce income and wealth inequality at a minimum cost to efficiency. Such policies include exploitation of property taxes, reductions in tax deductions that favour upper-income groups, investing in increasing the human capital of low-income groups, and reforming social benefits.

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The causes and consequences of rising inequality have attracted considerable attention, including the recent study by Thomas Piketty (2014). This has also touched off a lively debate on the appropriate policy response to rising disparities in income and wealth (Mankiw 2013, Berg, Ostry, and Tsangarides 2014). But this is just one of the many challenges facing ministers of finance – reducing public debt ratios and raising growth are also priorities. So what’s a minister to do? In a new paper, we shed light on this issue by examining how governments have successfully used fiscal policy to address distributive concerns, including during periods of fiscal adjustment. We also examine the policy options that countries can pursue to reduce inequality at a minimum cost to economic efficiency. These policy tools can provide finance ministers with credible options for reducing inequality without crippling economic growth.

Has fiscal policy contained income inequality?

Overall, there’s substantial variation in how much redistribution is done by governments, reflecting differing views on the appropriate role of the state. On average, social transfers and direct taxes reduce income inequality in the advanced economies by a third, as measured by the reduction in the Gini coefficient (Figure 1). Government transfers, such as pensions and family benefits, account for the bulk of this. On the tax side, personal income taxes make an important contribution. This analysis does not capture in kind benefits, such as education and health care, which reduce inequality further. In addition, it does not capture the impact of fiscal policy on market incomes and wages, which in practice has been difficult to measure because of insufficient data on behavioural responses to taxes and transfers.

Note: The impact of inequality of disposable income does not incorporate the redistributive impact of indirect taxes and in-kind benefits.

How has the redistributive role of the state changed over time? From the mid-1980s to the mid-1990s, fiscal policy was able to offset much of the underlying increase in market incomes (incomes before transfers and direct taxes). Since the mid-1990s, however, fiscal policy has not been able to counter rising inequality, reflecting reductions in the generosity of social benefits and reduced tax rates on upper-income individuals (OECD 2011).

Figure 2. Fiscal redistribution, 1985–2005

Source: Caminada et al. (2012).

Even as economies undertake fiscal adjustment, there is scope for addressing distributive concerns by choosing a mix of progressive consolidation measures. To assess this, we looked at 27 recent adjustment episodes in advanced and emerging Europe from 2007–12, using data provided by Euromod on market incomes, and Eurostat on disposable incomes. In about half of these economies, market income inequality – that is, inequality before taxes and transfers – increased during fiscal consolidations (Figure 3). However, in many cases, the increase was muted by the design of adjustment measures. In almost two-thirds of the economies, fiscal measures led to either a decrease in inequality (a decline in the Gini coefficient for disposable income) or at least partly offset the effect of a worsening of market inequality. This reflected progressive measures such as public sector wage cuts that were deeper for those at the top of the pay-scale than at the bottom; proportionately sharper reductions in benefits for those with higher pensions; and increases in income taxation.

Note: An increase in Gini coefficient indicates an increase in inequality. The Gini coefficient for market income is estimated by Euromod based on post-tax income survey data by Eurostat and simulated figures for taxes, using the Euromod micro-simulation model.

*Indicates that data for disposable income refer to 2007–11.

What about wealth?

Wealth is even more unequally distributed than income (Figure 4). Furthermore, this inequality has risen over time, reflecting deliberate policy choices. Over the past decades, revenue from these taxes has not kept up with the surge in wealth, and as a result, the effective tax rate on wealth has dropped from an average of 0.9% in 1970 to 0.5% today. Property taxes – an efficient and equitable tax – are underutilized in many economies, and yield an average of only 1% of GDP in advanced economies.

Figure 4. Gini coefficients for the distribution of income and wealth in selected economies, early 2000s

Implications for efficient redistribution

There is a wide array of redistributive policies that can help countries achieve their equity goals. As we discuss in our paper, whether these policies help or hurt economic growth – also a priority of most economies – depends on their design; for many economies, appropriate policy design can help them avoid or minimize such trade-offs. Such policies include greater exploitation of property taxes, reductions in tax deductions that favour upper-income groups, spending programmes that build the human capital of low-income groups, and reforming social benefits to increase incentives for work. Energy subsidies, which exacerbate inequality and retard growth, should be replaced with better targeted instruments (Clements, Fabrizio, and Parry 2013). In sum, there’s ample scope for policymakers to make a real dent in inequality.

Caminada, K, K Goudswaard, and C Wang (2012), “Disentangling Income Inequality and the Redistributive Effect of Taxes and Transfers in 20 LIS Countries Over Time”, Luxembourg Income Study Working Paper 581.